Venture Capital and Preferred Stock

Preferred stock has always posed something of a puzzle. Straddling the line between debt and equity, preferred stock has long existed in a shadowland between the realms of contract law on the one hand, and corporate law on the other. Depending on the situation, preferred stockholders have sometimes been entitled to the protection of corporate law fiduciary duties, and sometimes been left to lie in the contractual bed they have made. Historically, what little scholarship exists on preferred stock has consisted largely of calls for greater fiduciary protections for preferred stockholders. Preferred stock has taken on increased importance in recent years, as the favored mode of investment for venture capitalists. Moreover, in a recent trio of cases, the Delaware Chancery Court has restated – some have claimed re-made – the doctrinal treatment of preferred stock in venture capital deals, generating substantial confusion in the process. This Article takes a fresh look at the role of fiduciary duties in venture capital deals, examining the traditional rationales for fiduciary duties in corporate law and analyzing the extent to which they apply in the context of venture capital-financed startups. I conclude that the traditional rationales do not apply, and that venture capitalists, as preferred stockholders, should never be afforded fiduciary protections. Where preferred stockholders control the board, however, they should owe fiduciary duties to the common stockholders. Taken together, these conclusions provide what has long been lacking in this area of the law: a firm theoretical foundation and clear criteria for resolving disputes involving preferred stock

2018 Leet Symposium: Fiduciary Duty Corporate Goals, and Shareholder Activism—Introduction

On November 1, 2018, the Case Western Reserve University Law Review held the 2018 Leet Symposium, bringing together a group of nationally respected corporate law scholars to explore the current state of play between traditional shareholder wealth maximization and modern shareholder environmental and social activism. The Symposium also included a panel on the difficult role of in-house corporate counsel in a world where serving as a zealous advocate for the corporation may conflict with in-house counsel’s compliance function. This issue contains Articles that were presented on the occasion, together with the prepared remarks of the keynote speaker, SEC Commissioner Hester Peirce

Mismatch: The Misuse of Market Efficiency in Market Manipulation Class Actions

Plaintiffs commonly bring two distinct types of claims under Section 1(b) of the Securities Exchange Act of 1934: 1) claims of material misrepresentations or omissions; and 2) claims of trade-based market manipulation. Despite the distinctive features of the two types of claims, courts have tended to treat them identically when applying the “fraud on the market” doctrine. In particular, courts have required both types of plaintiffs to make identical showings that the relevant security traded in an “efficient market” in order to gain a presumption of reliance. The reasons for requiring such a showing by plaintiffs in a misrepresentation case are, however, inapplicable in market manipulation cases. Plaintiffs alleging market manipulation should not be required to demonstrate an efficient market in order to benefit from the fraud on the market doctrine’s presumption of reliance. If plaintiffs are made to make any showing at all, it should be a showing of loss causation

Selling Stock and Selling Legal Claims: Alienability as a Constraint on Managerial Opportunism

Scholars have long recognized the importance of market forces as a tool for disciplining the management of public corporations and reducing agency costs. If managers loot or otherwise mismanage the firm, the firm’s stock price will suffer, raising its cost of capital and leaving managers exposed to the threat of a hostile takeover. In recent decades, changing patterns of stock ownership have threatened the viability of this market check on mismanagement. Institutional investors, and particularly index funds, own an increasing portion of publicly traded firms, and face substantial liquidity and other barriers to simply selling their positions. To the extent this phenomenon attenuates market reactions to mismanagement, stockholders will have to look elsewhere for protection.More fundamentally, market discipline cannot effectively deter wrongdoing in final period transactions like mergers. Stockholders must look to legal remedies — such as fiduciary duty class actions or appraisal proceedings — for deterrence against managerial sloth or opportunism in connection with mergers. Historically, though, these remedies have been rendered ineffective by an agency problem (between stockholders and plaintiffs’ attorneys) every bit as problematic as the one (between stockholders and management) the remedies are intended to address. Recently, however, a new market has arisen with the potential to render these remedies more effective. If, instead of selling their shares, stockholders can sell their legal claims — as they are beginning to do in appraisal actions — agency costs in merger litigation can be reduced and managerial opportunism more effectively deterred

Lost in Translation: Law, Economics, and Subjective Standards of Care in Negligence Law

The law and economics movement has been a victim of its own success. Over the past four decades, it has generated an enormous specialist literature, often explicitly intended for other specialists. As is so often the case with increased specialization, the result has been escalating technical complexity accompanied by forbiddingly formal mathematics and a tendency to retreat into abstraction. As a result, economic analysis has often failed to provide general legal audiences with insight into important legal questions, even where the tools of economics would be appropriate and useful. This Article examines-and rectifies-just such a failure. In particular, this Article examines departures from a uniform reasonable person standard in negligence law. From an economic standpoint, individuals might be held to different standards of care because: (1) they differ in their costs of taking precautions (e.g., a good driver can take additional precautions more cheaply than a bad driver); or (2) they differ in the accident costs they generate when exercising a given amount of care (e.g., a good driver causes fewer accidents than a bad driver who is exercising the same precautions). Though the two possibilities lead to sharply different prescriptions, the law and economics literature has focused almost entirely on the former scenario, while neglecting the latter. By examining both possibilities, I provide a new and superior explanation of how tort law treats disabilities and professional skill, with the potential to change the way these important topics are conceptualized, taught, and ultimately adjudicated. In doing so, I also demonstrate the extent to which important legal insights can remain unappreciated when buried in an overly abstract mathematical literature

Information Bundling, Disclosure, and Judicial Deference to Market Valuations

This Article examines strategic disclosure behavior in the context of merger announcements. Merger transactions are frequent targets of litigation, including both fiduciary duty class actions and statutory appraisal actions. In either type of litigation, the fair value of the target company as a going concern is at least a part of the measure of damages. In recent years, courts have increasingly looked to market evidence of valuation—including the trading price of the target company’s stock prior to the announcement of the merger. This gives managers an incentive to minimize this trading price by strategically timing disclosures such that negative news is released prior to announcement of a merger while positive news is released simultaneously with or following a merger announcement. In many ways, the disclosure incentives managers face in the merger context mirror those they face in the securities fraud context. For years, securities fraud plaintiffs have typically been required to prove loss causation by using an event study to show a market decline upon corrective disclosure—a practice enshrined by the United States Supreme Court in Dura Pharmaceuticals, Inc. v. Broudo. Managers can make this task more difficult by bundling corrective disclosures with other potentially material news. Combining the corrective disclosure with additional bad news can make it impossible to determine what portion of any resulting price drop to ascribe to the corrective disclosure. Combining the disclosure with offsetting good news can reduce or eliminate the price reaction altogether. These types of strategic disclosure behaviors have important implications for the design of federal disclosure rules and judicial doctrine. To the extent that courts and regulators ascribe legal significance to the market’s reaction to information contained in corporate disclosures, those disclosures should be required to be made in a way that results in an informative market reaction. As such, this Article proposes that the Securities Exchange Commission should require several types of litigation-relevant information to be disclosed in standalone, unbundled fashion. In addition, this Article suggests refinements to judicial doctrine. These refinements are designed to: (1) minimize the incentive for managers to employ opportunistic disclosure strategies; and (2) preserve the flexibility to employ non-market valuation evidence where market evidence has been corrupted or obscured

Selling Stock and Selling Legal Claims: Alienability as a Constraint on Managerial Opportunism

Scholars have long recognized the importance of market forces as a tool for disciplining the management of public corporations and reducing agency costs. If managers loot or otherwise mismanage the firm, the firm’s stock price will suffer, raising its cost of capital and leaving managers exposed to the threat of a hostile takeover. In recent decades, changing patterns of stock ownership have threatened the viability of this market check on mismanagement. Institutional investors, and particularly index funds, own an increasing portion of publicly traded firms, and face substantial liquidity and other barriers to simply selling their positions. To the extent this phenomenon attenuates market reactions to mismanagement, stockholders will have to look elsewhere for protection.More fundamentally, market discipline cannot effectively deter wrongdoing in final period transactions like mergers. Stockholders must look to legal remedies — such as fiduciary duty class actions or appraisal proceedings — for deterrence against managerial sloth or opportunism in connection with mergers. Historically, though, these remedies have been rendered ineffective by an agency problem (between stockholders and plaintiffs’ attorneys) every bit as problematic as the one (between stockholders and management) the remedies are intended to address. Recently, however, a new market has arisen with the potential to render these remedies more effective. If, instead of selling their shares, stockholders can sell their legal claims — as they are beginning to do in appraisal actions — agency costs in merger litigation can be reduced and managerial opportunism more effectively deterred